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Yet Another Faulty Investment Strategy I Keep Hearing About

by Darwin on November 24, 2013

I was eating lunch with a co-worker today and he told me how he was getting completely out of stocks in his 401(k) account and switching to all cash and bonds. When I asked why, he acted like I was a dope and said, “the market is up over 20% so far this year. Since the long-term average is only 8%, it’s so far overdue for a correction, you’d be stupid to think this is going to continue”. To that, I answered that the same could have been said a few years ago (100 percent ago). See, what the market does over a discreet period of time has NOTHING to do with the long-term average annualized return. How many years do equities return 8%? Or even 7-9%? Very few! One year, the market’s up 25%, another year, it’s down 15%. That’s just how it goes. A “year” is a completely arbitrary timeframe in which people like to categories things like birthdays, when they get their raise and such. A very common fallacy that because the long-term annualized return of equities might be 8% or 9% has nothing to do with when you should buy or sell.

There are a fair share of finance bloggers I’ve seen touting the same strategies. They highlight that they’re selling into and out of stocks based on what they’ve done recently, but if anyone actually had the time or inclination to audit their results, I’d wager that they do no better than random chance over time.

Roulette and Coin-Flip Fallacy

This is not much different than a very common fallacy that people have lost fortunes betting on. People are under the mistaken belief that if you’re flipping coins and you have heads 4 times in a row that they’d be prudent in making a substantial wager on the 5th that it should be tails. After all, statistically, the odds of 5 heads in a row are only 1 in 32!? Who wouldn’t take that bet? The problem is, when making that bet AT the 5th flip, the odds are the usual 50/50. Transfer that to Roulette which also has the green spaces and your odds are even worse. I remember being at a casino watching a guy counting the number of hits on black and white and altering his bets accordingly based on what happened in past history. This is common and you’ll see it almost every time you go to a casino. No wonder casinos are so profitable!

The takeaway here is that there’s really no way to predict future market moves based on recent trends. Asset classes are going to move in a particular direction based on ever-changing circumstances, global developments and human behaviors that can’t be predicted. The current price reflects all known information at this time. You can always look to broader macro issues like record-low interest rates or political issues which may influence market moves, but in terms of simply relying on historical returns to predict future movements? It’s a fool’s game.

You need to have an investment strategy that represents your risk tolerance and time horizon and leave it be, save for occasional rebalancing (annually is probably more than frequently enough). Focusing on the lowest expense options (index funds and ETFs over actively managed funds and trading) will do much more for you in the long-run than trying to time the market.

Not sure your co-workers age, but if he has been investing for a few decades and is closer to retirement age this may be prudent (for him). If he is younger, and timing the market, let me fall in behind krantcents who said it better than I could.

Completely agree with your (Darwin’s) assessment of ‘driving with the rear-view mirror’ and the use of historical trends for discrete time periods. The ‘macro’ factors do have me baffled, and the artificially low interest rate environment is have a cost to other investment markets, just as it assists equities. Not sure Bonds is a safe place if your colleague is looking for an equity pullback. We shall see, in the fullness of time.